John Jansen reprints some BarCap research on the Miller-Moore amendment, and now I think I understand why so many finance types are so scared by it: they’ve misread it!

Here’s BarCap:

Proposed by Reps. Miller (D) and Moore (D), it would effectively replace existing repo and secured funding with unsecured borrowing subject to a margin, or haircut, of up to 20%. Specifically, in the case that a large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%…

No secured lender will want to be left in a trade with a bank in receivership where the regulators have converted the transaction into an unsecured loan at 80% of the original amount.

But that’s not what the amendment is proposing. Here it is:

An allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

Let’s say you have a secured claim of $1 million on a bank which has been taken over by the FDIC, and let’s say that unsecured creditors of that bank end up being paid only 70 cents on the dollar.

If the BarCap reading were right, the FDIC would first impose a 20% haircut on the $1 million, turning it into $800,000, and then convert it into an unsecured loan — which, at 70 cents on the dollar, would be worth just $560,000. The net effective haircut would be a whopping 44%. But of course this makes no conceptual sense at all, because unsecured creditors would end up being treated better, under this scheme, than secured creditors.

The way I read it, however, the Miller-Moore amendment allows up to 20% of the secured debt to be converted into unsecured debt; the rest of it is untouched. So you retain $800,000 of secured debt, worth $800,000, and now the remaining $200,000 is unsecured debt, worth $140,000. All in all your $1 million claim is worth $940,000 — a net effective haircut of just 6%.

No one likes losing 6% of their money, of course, but that’s a hell of a lot better than losing 44% of your money. And maybe if the sell side begins to understand how Miller-Moore really works, they might be less averse to it.

(HT: Alloway)

Ira Stoll notes that the Miller-Moore amendment has passed. He calls it the “Bair-Miller-Moore Haircut”, and he doesn’t like it; I, on the other hand, think it’s a spectacularly good idea. This is the meat of it:

Payments to Fully Secured Creditors: Notwithstanding any other provision of law, in any receivership of a covered financial company in which amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United States or to the Fund, as determined in the receiver’s sole discretion, an allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

In English, this means that if you’re a secured creditor of a bank which has failed and which the federal government has to pay money to rescue, you are only guaranteed to receive 80% of your money back. Beyond that, you’re treated as an unsecured creditor.

This achieves three important goals.

Firstly, it means that lenders to dodgy banks will actually have to start doing underwriting, rather than simply relying on their security interest. That keeps everybody honest, and will give the system a heads-up when banks start getting into trouble.

Secondly, it means that wholesale lenders no longer have the ability to jump the queue when it comes to seniority. Banks should repay their depositors first, and then their senior unsecured creditors, and then their subordinated creditors, and then their preferred shareholders; whatever’s left over goes to common shareholders. But increasingly the pecking order has been upended by allowing banks to issue secured debt, which in practice ends up being senior even to depositors. In some countries, banks aren’t allowed to issue secured debt at all; this amendment doesn’t go that far, but at least it makes the debt a little bit riskier for the lender.

Thirdly, it means that banks will be forced to look at the big picture when it comes to their assets, rather than simply using them as collateral for cheap and dangerous short-term funding. Writes Stoll:

The provision make it harder and more expensive for banks to raise capital, and therefore, harder to get credit flowing again into the economy.

This is not entirely true. The provision makes it harder and more expensive for banks to raise secured capital — but as we’ve seen, there are lots of other funding sources available to banks. The more unpledged assets that a bank has, the easier it is for that bank to raise both unsecured debt and various forms of equity.

Conceptually, this is entirely what we want. If I have an asset worth $1 million, I can either borrow $900,000 against that asset and pay interest on the loan, or else I can sell off equity stakes in that asset for $1 million. I’m not sure why the former is a better idea than the latter, when we’re trying to deleverage the banks and move to a more equity-based (and less debt-based) world.

Does the Miller-Moore amendment make banks more liable to liquidity runs? Yes, but on the understanding that (a) they only become more vulnerable insofar as they’re reliant on the short-term repo markets, which is something we want to discourage; and (b) they have access to the Fed’s discount window anyway, so it’s not as though all secured funding sources can disappear overnight.

Why does Stoll love secured creditors so much? He says that “the rights of secured creditors took a beating in the Chrysler bankruptcy” — but that’s not true. They still had the right to provide DIP financing themselves (the role played by the government) or even to push Chrysler into liquidation. They sensibly didn’t exercise those rights, because doing so would have cost them an enormous amount of money compared to what they ended up getting. But the rights themselves were untouched.

The Miller-Moore amendment, by contrast, really does hit secured creditors. That’s a very good idea. Next up, let’s allow bankruptcy judges to modify mortgages, too.

Update: One more thought on this subject. Most secured funding for banks comes from the repo market, where banks borrow against securities they own. But what are banks doing holding so many securities in the first place? Shouldn’t their assets mainly be loans, which can’t be repoed?

It’s good that we’re moving to an opt-in system for debit-card overdrafts. But in order to get there from here I have a feeling that we’re going to have to dodge a lot of, um, personalized communications from our banks:

SoundBite’s Debit Card Overdraft Opt-In solution can proactively reach consumers through any combination of automated voice, text, and email messaging. Attempts to reach a consumer can escalate from one channel to another — such as from an email to a voice message to a text message — in order to increase reach-ability and response rates.

Maybe this is why the Fed’s model letter included a way for consumers to opt out, even though they’re opted out by default. If you formally communicate with your bank to opt out, will that stop them pestering you to opt in?

Today the squid is showing its human face — you know, as opposed to wrapping itself around one. Goldman deserves to be applauded for two things today: first of all Lloyd Blankfein’s admission and apology that his bank “participated in things that were clearly wrong and have reason to regret”, and secondly its $500 million 10,000 Small Businesses Initiative, under which it will team up with community colleges, business organizations, and Community Development Financial Institutions (CDFIs) — all with the aim of removing barriers to growth in the small-business sector of the economy.

As a board member of a CDFI myself, I can attest that the kind of funding that Goldman is providing — some $300 million in loans and grants — can make a world of difference to our members. We’re happy to do a lot of work underwriting loans to small businesses, but by their nature these things are risky, and if someone like Goldman Sachs steps in to backstop losses on a portfolio of small business loans, there’s no shortage of borrowers we are eager to be able to help, often in conjunction with public organizations like NYC Business Solutions. All too often there’s lots of goodwill in such places but a serious shortage of lendable funds: initiatives like Goldman’s should help change that. And given that small businesses are a key driver of employment growth, there has never been a better time to do this.

I also asked Goldman which activities, exactly, Blankfein had in mind when he talked about doing “things that were clearly wrong”. They pointed me to his Handelsblatt speech:

The industry let the growth and complexity in new instruments outstrip their economic and social utility as well as the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

So complex structured products would be one example of what Blankfein was talking about; another, I was told, would be cov-lite loans. Would that more bank executives went public in describing such things as “clearly wrong” in normative terms, rather than simply money-losing mistakes in hindsight.

Economics of Contempt defends too-big-to-fail banks:

The point of creating CDOs was to generate a mezzanine tranche, which investors, who had a seemingly insatiable thirst for yield, would gobble up. Goldman (and other dealers) couldn’t place the super-senior tranches, so they held the super-seniors on their books and hedged all that risk by buying CDS protection from AIG (and the monolines)…

As you can imagine, all the risks that a major dealer bank has to manage on a daily basis—the constantly changing level of their exposures, how those exposures all interact, etc.—gets extraordinarily, mind-bogglingly complicated. The major banks all made huge investments to develop the technological capacity to manage those risks, and it’s pretty clear they didn’t invest enough in their risk management systems. There are only two banks that I’ve seen that clearly did make the necessary investments in risk management (Goldman and JPMorgan, not surprisingly). So there are undoubtedly economies of scale there.

There are two problems with this. Firstly, the two banks which made the necessary investments in risk management were not the two biggest banks. Neither Goldman nor JP Morgan is small, of course — but Citigroup and Bank of America, both of which had woefully insufficient risk-management systems, were bigger still, and saw none of those “economies of scale”. There’s no indication that bigger banks are better at risk management than smaller banks; in fact, bigger banks tend to have more places in which they can hide nuclear waste from senior management and the board.

EoC also implies that bigger banks are more likely to be able to mark their assets to market; again, that’s not really true, as a glance at Citigroup will tell you. The key variable here isn’t size, it’s the quantity of illiquid assets that a bank is holding. (Loans, which are the bread and butter of commercial banks if not of Goldman Sachs, are by their nature illiquid.)

And then there’s EoC’s point about Goldman holding illiquid CDOs on its balance sheet and then hedging the associated risks in the CDS market. Is that something Goldman can do because it’s big, or is it a mistake which Goldman made and which it’s unlikely to repeat? Let’s ask Goldman CEO Lloyd Blankfein, who recently gave an interview to Peter Lee of Euromoney (behind a firewall, unfortunately):

We think there should be a much, much higher return for holding illiquid assets. Right now, our asset quality is a lot higher, we’re carrying more liquidity and the bar just got higher for carrying anything else. But for the right profit opportunity, we would put more illiquid assets on our balance sheet.

Super-senior CDOs are never going to provide that kind of profit opportunity. Goldman’s shenanigans in the CDO market were an aberration, and were not something societally useful which sprang from being large. In any event, there’s really nothing in EoC’s argument which couldn’t apply to banks with only $100 billion in assets, say, as opposed to $1 trillion. As James Kwak notes, economies of scale top out long before bank size does; beyond that, it’s all moral hazard.

Mark Gimein says that we shouldn’t worry too much about the problem of too-big-to-fail, because the alternative to one big bank failing is lots of small banks failing:

What we’ve seen in virtually every crisis is that bank failures and other economic catastrophes are highly correlated, in large part because financial players do not lock themselves up in rooms and gaze at crystal balls. They watch what everyone else is doing and then they do the same thing… The problem of the giant institution that’s an outlier and needs to be bailed out when everyone else is doing fine is one that exists only in theory. What happens in practice is that many banks, large and small, make the same mistakes and fail at the same time. In other words, it tends to be not single banks that need to be bailed out, but big swaths of the whole industry. Breaking up the biggest banks won’t change that.

This misses two key points. The first is that big banks are too interconnected to fail in a way that small banks never are. And the second is that big banks have balance sheets which are so enormous that they can hide all manner of nuclear waste there (as well as in purpose-built off-balance-sheet vehicles) in a way that small banks could never comprehend. Yes, there have been a lot of small bank failures over the course of this crisis. But none of them were a result of those small banks keeping on their own balance sheets a huge quantity of unfunded super-senior tranches of synthetic collateralized debt obligations. You need to be big to be that stupid.

When small banks fail, it’s generally because they make long-dated real-estate loans at high valuations or low interest rates or both. Big banks, by contrast, can fail ways that small banks can never dream of. And when they fail, the consequences for the payments system generally can be disastrous. So yes, breaking up big banks does significantly reduce tail risk in the financial system. No matter what Goldman Sachs says (and they’ve been feeding me the Gimein line for a while now).

Go Fed! In a very CFPA-ish move, the Fed has now announced that effective July 1, no bank can impose overdraft fees on its customers for ATM or debit card transactions, unless and until they explicitly ask for that “protection”. And they even come with a quote from Ben Bernanke talking about “an important step forward in consumer protection”, which is not the kind of language we’re used to hearing from Fed chairmen.

One weird thing, though: in the letter the Fed has published as a model for banks to follow, consumers are given two choices at the bottom: the first choice is opting out of overdraft protection on ATM and debit-card transactions, while the second choice is opting in. That’s confusing, because opting out is the default option: if you simply ignore the letter and do nothing, you’re opted out automatically.

Why ask customers to sign and date a piece of paper to opt out of something they’re already opted out of by default? I’d much rather see language saying “if you don’t want us to authorize or pay overdrafts on ATM and everyday debit card transactions, you need do nothing”. But that’s just a niggle: this is an important step forwards.

Update: The Center for Responsible Lending emails to point out all the things which the Fed didn’t do, including capping the number of overdraft fees that a bank can charge per day, and preventing banks for charging far more in fees than the total size of the transaction. So there’s still work for the CFPA to do!

Paul Solman is taking questions for Sheila Bair. If I could ask her just one question, it would be about her actions taking over WaMu and wiping out all its senior unsecured debt. That’s the wholesale interbank market right there, and in the wake of the WaMu collapse, banks pretty much stopped lending to each other, fearful that at any point Bair could step in and wipe out billions of dollars in assets. The ensuing credit crunch was responsible for trillions of dollars in stock and bond-market losses, and Tim Geithner, for one, was furious at Bair for her precipitous decision.

So the question is this: was the WaMu intervention a mistake, given the knock-on effects it had on the broader economy? Or, more generally, is there anything Bair would do differently, in hindsight?

Bair’s a political beast, and I suspect she’ll brazen it out, saying that her WaMu decision was the right one. But that would put her in the dubious company of all the other executives who feel they have nothing to apologize for. Is it too much to hope that she might show a glimpse of humanity or fallibility?

Landon Thomas’s story on dodgy shipping loans has some absolutely astonishing numbers, the biggest of which is simply the size of the market, which he pegs at a whopping $350 billion.

The story is pegged to Eastwind Maritime, a shipper which went bust this summer owing $300 million on a fleet of 55 ships. That’s about $5.5 million per ship, which isn’t very much when the average five-year-old vessel was valued at about $88 million as of June of 2008. But things are different now:

Aozora Bank, a Japanese bank that in addition to being one of Eastwind’s top lenders is a major creditor of Lehman Brothers, found to its dismay that the value of the 12 Eastwind ships it now controlled was considerably lower than its $77 million exposure.

The biggest at-risk bank is German state-owned lender HSH Nordbank, with $50 billion of shipping loans. So far, it’s provisioned just $800 million of those, although it’s also received $19.4 billion in support from its shareholders, the regional German states of Hamburg and Schleswig-Holstein.

The problem is that the collateral on these loans is the ships themselves, and many of these ships are simply worthless given the glut of newer ships coming on to the market. So far, the shippers have been making their interest payments, which has helped the banks to avoid writing down the loans. But if the business dries up, the banks aren’t going to be happy with their security. It’s not a pretty picture for anybody concerned.

Andrew Ross Sorkin confirms what most of us have long suspected:

One of the frustrating parts of researching my book came when I finally got to ask the question of Wall Street chief executives and board members that you just raised: Do you have any remorse? Are you sorry? The answer, almost unequivocally, was no. (Or they just didn’t answer.) They see themselves as just one part of a larger problem, with many constituencies to blame.

Many of the most senior members of management on Wall Street now consider themselves “survivors,” as if they were cancer survivors or something. That’s the word they use. While many of them are self-aware enough to politely nod at the notion that they received help and were part of the problem, they seem reluctant to acknowledge they were “rescued” or “saved.”

One of the key drivers of the crisis was the hubris and general lack of humility of senior bank executives. This is connected to the issue of executive pay: almost everybody thinks he deserves what he’s earning. But the only way you can deserve an eight-figure pay package is if you’re really on top of what’s going on in your bank. Ergo, everybody thought they were on top of what was going on in their banks, even when they weren’t; lower pay and more humility would have helped enormously in curtailing some of the most egregious excesses.

If bank executives (with the notable exception of John Reed) see no need to apologize for destroying the global financial system, they are still part of the problem and are very unlikely to be part of the solution. Which bodes ill for the future.